Why diesel price hike is good news for investors

The government proposes to hike diesel prices by one rupee every month over the next 10 months. To many who consume diesel for powering their vehicles, this may sound inflationary. However, investors should be happy about this move. It is one of the most necessary actions needed to put government finances in order. The BSE Sensex and NSE Nifty have moved to a two-year high.

Here are few pointers:

Government subsidy burden declines The government sells diesel, kerosene and liquefied petroleum gas or LPG at prices that are lower than market prices. According to budget estimates, fuel subsidies account for close to Rs 2,00,000 crore annually. Diesel alone accounts for close to Rs 82,000 crore and for 38 per cent of the total petroleum product consumption in India, according to a report by National Institute of Public Finance and Policy, a New Delhi-based think tank. Every increase in the retail price of diesel would bring it closer to the market price.

Government finances: The government currently asks state-owned oil companies to sell diesel at administered prices. The government then reimburses them for the difference. The government cannot afford to keep prices low as it spends more than it earns overall from tax revenue and other resources (fiscal deficit). Media reports also suggest that kerosene prices prices could be hiked by Rs 10 over the next two years. This should slowly bring down the subsidies that contribute to the high government expenditure and lower the fiscal deficit.

Fiscal deficit: The Indian government spends more than it earns in terms of tax revenue and other means. The fiscal deficit equals the money the government has to borrow from RBI to meet the expenditure. To reduce the fiscal deficit, the government has to cut expenditure and raise resources. The government has not succeeded in doing both in a meaningful way, according to a recent report by Kotak Securities. The Indian government is likely to spend close to Rs 3,00,000crore on providing jobs, cheap fuel, food and fertiliser by 2013-14, the report adds. The increased borrowing from the government leads to more demand for money and high interest rates.

RBI to watch: When government spends more than it earns, it has to borrow money from Reserve Bank of India. RBI does not want to print money as it increases the money supply and adds to inflation. It has to make the money available from the existing pool. This puts pressure on borrowing rates as RBI has to make money available to the government as well as for businesses and individuals. The government gets priority in this borrowing and businesses have to seek other sources of funding that are expensive. This slows down the economy as businesses put new expansion on hold. High interest rates squeeze profitability of businesses and reduce consumption.

Foreign capital flows: India's foreign currency reserves could be under pressure as the current account deficit (Excess of imports over exports and other receivables) touches a record high. The rupee could be under pressure and needs foreign institutional investors to bring in capital flows into the equity markets. A programme to cut subsidies should help improve overseas investor sentiment and this could be positive for foreign flows.

Oil marketing companies to benefit: State-owned companies like BPCL, HPCL and IOC have absorbed close to Rs 82,000 crore of diesel subsidies in 2011-12. They have been selling diesel at administered prices. The hike in diesel prices would allow them to slowly sell diesel at a higher price and reduce their burden.

To know more about the economics and politics of diesel, read this link Read more

Swaminath S A Aiyar argues that inflation could be squeezed by staggering fuel hikes Read more

$ 2,32,770

In 2011-12, petroleum products contributed Rs 2,32,770 crore to the central and state government taxes, according to the National Institute of Finance and Policy in New Delhi. According to the government budget documents for 2012, close to Rs 200,000 crore is spent on subsidizing fuels like diesel, kersone and LPG. This means, there is very little money available to spend on India's social infrastructure from the sector.

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